PE in Africa: confidence with caveats

June 2016 | COVER STORY | PRIVATE EQUITY

Financier Worldwide Magazine

June 2016 Issue

As a global opportunity destination, the continent of Africa is as compelling as they come – a magnet for transaction-hungry investors and dealmakers, including private equity (PE) funds hunting high-growth yields.

Beyond all doubt, the PE industry in Africa is a burgeoning arena at present, with fundraising on an upward trend and dealmaking activity continuing to be strong, even in the context of an increasingly volatile global economic environment.

According to the African Private Equity and Venture Capital Association’s (AVCA) ‘Annual African Private Equity Data Tracker’ (2016), the total value of PE funds on the continent was US$4.3bn in 2015 alone. This figure is based on final close, with three funds accounting for 65 percent of the total amount raised.

Drilling down further, between 2010 and 2015, confirms AVCA, African PE firms closed funds totalling US$16.2bn, with half of the total number of funds raised being above US$100m in size. Moreover, half of the funds were targeted at specific regions or countries within Africa, while a third of the funds were Sub-Saharan and the remainder, Pan-African.

In terms of transaction numbers, 823 PE deals totalling US$21.6bn were reported in Africa between 2010 and 2015. Last year specifically, there were fewer deals above US$250m in size compared with 2014, resulting in a lower overall total deal value of US$2.5bn. However, deals below US$250m in size – the ‘bread and butter’ PE deals – have been stable in recent years, with the total deal value increasing only slightly in 2015, relative to 2014.

In a regional context, African PE activity is booming, with East and West Africa continuing to be attractive to PE firms: 25 percent of deals by volume were done in West Africa between 2010 and 2015, with East Africa hosting 17 percent of deals during the same period. Furthermore, AVCA reveals that 42 percent of the value of deals closed in Africa between 2010 and 2015 were multi-region deals. Multi-region deals have a footprint centred on a number of regions and are not exclusive to one particular region within Africa.

Corroborating and complementing AVCA’s data is the ‘Africa Private Equity Confidence Survey 2015’ published by Deloitte and the South African Venture Capital and Private Equity Association (SAVCA) – an examination of the PE landscape in Africa which, whilst acknowledging that the continent attracts but a small proportion of the world’s PE money, highlights a number of PE success stories and notes that Kenya, Nigeria and South Africa remain the favoured destinations for PE activity.

Further revelations to emerge from the Deloitte/SAVCA survey include the recognition of a so-called ‘African middle class’ which appears to be driving consumer-focused sectors such as telecommunications, utilities, financial services and food and beverages. There is also an ‘increased awareness’ of PE as an asset class, with pension funds in the region recently opening up to the possibility of investing in PE.

Furthermore, Michael Rudnicki, head of private equity at KPMG in South Africa, attests that Africa is increasingly becoming home to many global PE players, pointing out that the Carlyle Group, KKR & Co and TPG (TPG Growth) have made major investment forays into Africa in recent years. “Additionally, there have recently been growth opportunities for South African funds such as Rockwood and Ethos, with portfolio expansion into many of the African regions,” confirms Mr Rudnicki.

Beyond all doubt, the PE industry in Africa is a burgeoning arena at present, with fundraising on an upward trend and dealmaking activity continuing to be strong.

However, although the outlook for 2016 is promising and investors remain keen, the ongoing challenges facing African economies – such as currency devaluation, the economic slowdown in China and low oil and commodity prices – remain a significant concern despite the PE positivity enveloping the continent.

PE challenges on the continent

Of course, across a continent as expansive as Africa, there are a host of challenges that need to be addressed by PE practitioners keen to make their mark. Demanding and difficult for sure, but not insurmountable. “The key challenges remain high price multiples for larger transactions and scarce sizeable assets, although many family businesses exist which require capital injection for expansion and growth,” says Mr Rudnicki. “Political instability, corruption, weak currencies and high regulatory constraints often foster a perception of bad investment jurisdictions.”

According to Hugh Naylor, head of Private Equity at Trinity International LLP, low commodity prices is a concern in commodity rich countries, as is currency devaluation, perhaps the biggest macroeconomic challenge pervading the continent. “While the more established PE funds with a large number of portfolio companies have enjoyed a number of successful exits recently, there are lingering concerns about just how robust the market is, with limited buyers of assets and IPOs rarely being a viable alternative,” he says.

Despite the challenges, PE in Africa remained resilient in 2015 and so far in 2016. “PE firms that have experience operating on the African continent are typically well-versed in navigating sometimes complex and diverse economic, regulatory, financial and cultural environments across different countries,” explains Dr Dorothy Kelso, director and head of Research & Strategy at AVCA. “And it is their ability to grow portfolio companies notwithstanding external factors that gives PE investors an edge over other types of investors and points to further growth in the size of the PE industry in Africa.”

Overall though, many analysts, such as Dr Martyn Davies, managing director of Emerging Markets & Africa at Deloitte, are of the opinion that due to the nascent nature of the majority of stock markets on the continent and shallow formal capital markets, it is almost natural that PE will be the dominant form of investment in most countries within Africa.

The global economy

Over the best part of the last decade – essentially since the 2008 financial crisis brought the world’s financial markets to their knees – the global economy has been a decidedly volatile environment, with stagnating growth in China, a sharp deceleration in the growth of global trade and the economic consequences of El Niño among the ongoing challenges, not to mention the overlay of geopolitical tensions that tend to magnify economic challenges. Needless to say, analysts have been fiercely debating the extent to which these challenges are impacting investment activity in Africa.

There is little doubt that the global economic slowdown has had an adverse impact on the continent, particularly with sharply falling commodity prices giving rise to currency devaluations. But this may represent an opportunity for such countries to develop non-resource based industries, according to Mr Naylor. The biggest concern, he believes, are the more inward looking and increasingly protectionist, economic policies that exist in the developed world – policies which can only have an adverse effect on the long-term development of Africa and, additionally, may be mimicked by African countries conducting trade within the continent.

“Currency and commodity price moves have obviously been extreme and have had an impact on the short to medium-term investability of certain countries, at least in some of the more commodity export-dependent ones,” states Nick Tims, a managing director at Investec Asset Management. “US dollar liquidity has in some countries been a particularly difficult issue, while parallel unofficial exchange rates have led to dealmaking going on hold until we see official exchange rate stability. In some cases, valuations still need a reality check.” However, Mr Tims points out that Africa remains one of the highest economic growth destinations in the world, and the continent’s ongoing structural paradigm shift will be the major catalyst for continued deep rewards.

For his part, Dr Davies is confident that PE practitioners are taking appropriate measures to limit the impact that the fragile global economic environment is having on dealmaking activity across the continent. “Growth in the East African region continues to provide yield for investors. But the rapid deceleration of growth in previously leading economies such as Nigeria and Angola has resulted in a significant drop off in investor interest,” he says. “Compounding the challenge is the uncertainty around currency valuations and possible devaluations which increases the risk of investment. However, the devaluation of local currencies is, to an extent, resulting in a repricing of African economies which is creating new opportunities for PE investors who are now able to buy assets at a cheaper price. Many PE firms are seeking to deploy capital in Africa and are now just seeking out good assets with good management teams.”

Despite the challenges being wrought on the continent by the vagaries of the global economy, overall the outlook for deal activity remains positive. In addition, the continent’s young population, high rate of urbanisation and rapidly growing middle class are also serving to attract investor interest, with consumer driven sectors – such as telecommunications, utilities and financial services – strongly benefiting. In fact, it is these sectors that have attracted the highest investment from PE funds since 2010. In terms of regional hotspots, West Africa received the highest share of PE investment, followed by South Africa.

Regulatory and other challenges

In addition to the destabilising effects of the volatile global economy, as well as the impact of a devalued currency, a slump in commodities prices and corruption, there are also a raft of regulatory issues that PE firms need to comply with as they put their dealmaking plans into action.

“A key regulatory issue is the fragmentation of not just the African continent, but also most of its regions, with the East African Community (EAC) perhaps being the only exception when it comes to regional integration in Africa,” suggests Dr Davies. “Regulatory and compliance complexity is a constant hurdle that needs to be overcome when seeking to build an intra-regional company that operates across numerous jurisdictions.”

Adding to these difficulties is the fact that Africa remains an expensive continent in which to do business, with due diligence costs particularly high, especially in situations where the target is based in multiple jurisdictions. Furthermore, outside of South Africa, there is a lack of appropriate leveraged finance. “While no different to any other developing or even developed countries, regulatory uncertainty does not help and anti-bribery and corruption remains a very real issue requiring extensive due diligence and understanding,” notes Mr Naylor.

Further contentious issues arise when discussions switch to Africa’s tax systems, particularly in the context of withholding taxes and the flow of currency controls found in many African countries. Moreover, the concept of ‘reverse VAT’ is a distinctive component of African countries’ tax legislation, a VAT charge levied in specific instances on expenses incurred in respect of services provided by non-tax residents. According to Mr Rudnicki, “new merger regulations by the COMESA Competition Commission (CCC) should also be considered when looking at potential deals in any of the applicable countries”. In addition, he explains, “other regional regulations apply, such as the Foreign Account Tax Compliance Act (FATCA) and the local Competition Commission in South Africa”.

PE in Africa: 2016 and beyond

According to the AVCA, SAVCA and many others, the outlook for PE in Africa in the months and years to come remains positive. Despite the potential impact of the vagaries of the global economic environment on the continent, fundraising and dealmaking activity is expected to stay strong, with numerous trends and developments poised to shake up the status quo.

Factors such as the strong underlying economic fundamentals associated with demographic trends, rapid urbanisation and the implementation of business-friendly policies by African governments are all set to continue to play their part in supporting investment in, and the growth of, PE-backed companies. “PE investment is likely to continue to be geared towards the fast-moving consumer goods (FMCG) sectors, with infrastructure, real estate and energy also likely to attract substantial interest from investors,” forecasts Dr Kelso. “West and East Africa should continue to remain attractive destinations for PE investment on the continent. Notwithstanding, the current uncertainty around emerging market economies, low commodity prices and pressure on local currencies, many PE investors in Africa have the requisite skills, experience and knowledge to continue to invest, grow and add value to portfolio companies.”

Stoking the continent’s PE fires is the money raised by African PE funds during the last 18 months, with a significant amount of dry powder available, especially for larger deals in excess of $100m. This space, according to Mr Tims, is crowded, with many South African corporates having joined the fray in recent times. “Expect more PE to PE deals, and the continued creation of platform strategies, or build vs. buy, in this context of relative deal scarcity, he says. “This scarcity also has implications for pricing and it is clear to us that value more generally resides in the mid-market space.”

Most African fundraising for 2016 is expected to focus on regional, sector and credit funds, partly because many of the larger Pan-African funds have recently closed funds and are in investing mode.

For some, PE has been in a holding pattern this year but the volume and value of PE fundraising and buyouts should increase as we near 2017. “The major trend that I foresee is a greater transactional emphasis in the East African region, where previously it was arguably more Nigeria and West Africa focused,” says Dr Davies. “Due to continuing low oil prices and fiscal headwinds in many oil-propelled economies, this trend will continue over the short-to-medium term.”

Ultimately, although Africa is a continent currently displaying substantial PE confidence, it is a confidence that comes with a number of caveats.